Second quarter GDP for the U.S. could be set to impress, but according to Chief Cross-Asset Strategist Andrew Sheets, investors need to look below the surface.

This Friday, the U.S. Department of Commerce reports its advance estimate of second quarter GDP. It’s likely to be a whopper. Our U.S. economics team at Morgan Stanley Research expects it to register at +4.7%, and given the unusually large number of moving parts at work this quarter, a 5-handle is possible.

In aggregate, this ‘stockpiling’ in exports could be responsible for 1.5 percentage points of our 4.7% 2Q GDP estimate.

A few days later, the June reading of the U.S. Personal Consumption Expenditures Index (PCE) could show a slight downtick in core inflation. Robust growth and modest inflation; what could be better?

Try not to get carried away. Amid the inevitable cries of ’Goldilocks’, a more important story lies below the surface.

An unusually large number of one-off factors appear to have boosted 2Q GDP, many of which are directly related to escalating trade concerns. As companies and countries race to secure supplies that may become expensive later on, exports have surged and inventories have swelled.

An Increase in Stockpiling

2018 has seen a steady increase in trade tensions, and trade actions, between the U.S. and its trading partners. The U.S. imposed tariffs on washing machines and solar panels in January, on steel and aluminum in March, and on US$34 billion of goods from China on July 6. In response to these measures, China and the European Union have announced countervailing tariffs of their own.

For Michael Zezas and our U.S. public policy team, this fits with a narrative of continuing escalation in trade tensions, a trend we expect to persist until it comes up against greater political or market pressure. As we have yet to see either, companies are facing this new backdrop with a familiar mantra: ‘Hope for the best, prepare for the worst’.

At least that’s what Ellen Zentner and our U.S. economics team see when they peel back the U.S. data. As Ellen noted in a recent New York Times op-ed, countries have significantly increased the volume of goods they import from the U.S., likely with a view towards securing goods before new duties are applied. Two pointed examples are that U.S. soybean exports were up almost 9,400% annualized over the last three months, and the export of crude and fuel oil surged by 244% over this period.

In aggregate, this ‘stockpiling’ in exports could be responsible for 1.5 percentage points of our 4.7% 2Q GDP estimate.

A Mounting Impact

‘Stockpiling’ also appears to be at work for U.S. companies, albeit to a more limited extent. The inventory build in 2Q is tracking at +US$38 billion, versus a +US$10 billion rate in the prior two quarters. And what’s more interesting is the areas where those inventories are building, which have material overlaps with trade: electrical goods, machinery equipment, motor vehicles and parts.

In total, our U.S. economists see net trade and inventories making up 2.2 percentage points of our 4.7% US GDP estimate, the highest combined contribution since the fourth quarter of 2011. Their concern is that since they are one-off adjustments, both contributions are unsustainable and represent a pull-forward of demand that will need to be given back. U.S. GDP was +4.6% in 4Q11, then averaged +1.6% for the next five quarters.

The latest round of trade tensions may also matter for inflation. Despite all the ink spilled on trade this year, the impact on end prices appears minimal. But this may be set to change. My colleague Guneet Dhingra, strategist for U.S. inflation and rates, notes that, so far, tariffs have focused on the components of production, which tend to take time to work their way into final prices. But when tariffs target consumer goods, the impact can be rapid. Remember those tariffs on washing machines? The ‘laundry equipment’ category of the Consumer Price Index (CPI) is up almost 15% year on year.

Why does this matter? Of the US$34 billion in items targeted in the initial set of China tariffs, 3% were consumer goods. In the next US$200 billion set of proposed items, 33% are consumer goods—a much larger share of a much larger number. And if the tariff list expands to the remaining US$250 billion of Chinese goods, of which 60% are consumer goods, this will result in a more acute impact of incremental tariffs on CPI.

The Bottom Line for Investors

What does this mean for markets? While next week’s print will tempt with a narrative of strong growth and modest inflation, we think that 2H will follow a different storyline, with decelerating growth and rising inflation across major regions. More tactically, we’re also moving out of a July reporting period that has historically been supportive of risk into an August-September stretch that is usually one of the most challenging.

Near term, we have turned more defensive in our equity sector choices across regions, downgrading small caps and tech in the U.S. and upgrading utilities in Europe. Our view that U.S. growth moderates from a 2Q high drives our below-consensus forecasts for U.S. yields, and our rates strategists’ preference for flatteners. And despite a July lull, we think that volatility is attractive to own across a number of asset classes, specifically oil, U.S. small caps and high yield credit.